If you have a fresh business concept or an already established company, at any point in time it is quintessential to have a precise financial model for the complete operation of the business. The process of creating and maintaining a reliable financial model represents the past, present and future aspects of the company and is based on specific mathematical models or calculations, done with the help of statistical tools.
Constructing a financial model is important for the following purposes:
- Construct or reconstruct financial decisions, cash flows and revenues.
- Expansion or take-over of a current business, which is primarily in business valuation
- Starting a new venture
- Attracting investments
- Decide the market direction of its products or strategic planning for finding new arenas
- Calculate the cost of capital for new projects
- Capital budgeting and resource diversions
- Market comparisons and performance chart organizing
- Annual financial reports and statements
A financial model may be created for the entire performance parameters of the business or for a particular event. The primary task of an analyzer who is assigned the task of creating a financial model is to collect all the variables representing the company figures. These figures are then placed in a preset position based on theories and suitable model is structured around them. Specific mathematical formulae are derived from these variables and the event or performance is portrayed through spreadsheet language.
Variable section for constructing a Financial Model
The accuracy of a model depends on the selection of proper variables used for construction. A skilled analyzer will be able to selectively pick out only the relevant ones, and this depends usually on the objective of model creation. Variables significant for reconstruction is different from the ones required for forecasting. Each of the variables picked out should be powerful enough to have an impact on the model during its testing and use.
The sensitivity of the models to these variables can appear in two ways when an input is given to the built model:
- Any kind of change in even a single variable can influence the final outcome or result of the model.
- A change in one variable can cause an alteration in one more of the other variables used in the model.
A simple example can be used for illustration. You want to forecast the revenue growth of a company and the model used for this is the 3-statement model. To construct this model, you need three variables: balance sheet, statements of income and cash flow and the schedules for supporting the data. If there is a change in the income, the revenue created by the model will be altered and so will the cash flow. An ideal model should be presented in a simple format and give the desired assumptions to the user.